The Federal Reserve Explained!

It’s true–paper money makes it easier to cause inflation. Much easier. A government can “just print” more money. The US did this in the American Revolution, and again during the Civil War. Some people say we’re doing it now. I don’t think that’s quite right, because of the way the Federal Reserve works, which few people understand. I’m going to try to explain it for non-economists, in a historical context.

First, inflation. Nobody wants inflation, right? Well, not necessarily, Historically, inflation increases growth. If you’re thinking of buying a car, and you know that next month, the car will cost more, you’re much more likely to rush out and buy a car. Inflation typically makes people buy now, rather than defer buying. BOOM! economic growth. And because there’s more money around, it’s cheaper to borrow, so it’s easier to start new businesses.

And if like me, you have fixed loan costs, inflation can be great. The mortgage payment takes a big percentage of my monthly income. If there was, say, 5% inflation, and my wages went up to match, that mortgage payment would take a smaller and smaller percentage of my monthly pay. In a few years, I’d be laughing at the mortgage payment and enjoying more money to spend on other stuff, like cars, which makes GM happy, which puts money in its employees’ pockets.

Would my wages go up? Again in the classical model they would have to–because there’s more and more money, more and more businesses could afford to pay me more. My employer would have to keep up.

Who does inflation hurt? Well mostly people who lend money. The lender loaned me 1000 bucks expecting to get 1500 back. He gets the 1500, but now, because of inflation, it doesn’t have the purchasing power it used to. The lender feels he’s been cheated. The stability of contracts is undermined–you can’t be sure what you’re going to get. And people on a fixed income would be hurt as well.

The above is an oversimplification, but American history broadly shows a long tension between men on the make, who want low interest rates, paper money, and inflation, and people who’ve made it, who want a specie standard and fixed prices and values. Ben Franklin, for example, argued for paper money, indexed to what we might call the “gross colonial product,” in this essay. He was an entrepreneur, an innovator, a man on the rise. His whole career, as a writer and printer, was based on generating value from marks on paper.

All the colonies printed paper money of one kind or another. Pennsylvania’s paper money, which clever Ben got the contract to print, worked extremely well.

Other colonies had more problems.

The biggest problem of paper money is runaway inflation. You can always just keep printing it. Soon there’s so much in circulation that prices escalate wildly and frighteningly, and serious investment becomes impossible. The most famous example is Wiemar Germany,[1. although if you held a mortgage on a house in Weimar Germany, the inflation enabled you to pay off your house with pocket change.] but the US experienced the same thing during the Revolutionary war, when it printed Continental dollars, the British liberally printed counterfeits, and by the end of the war the paper money was nearly worthless.

So how can you balance the expectations of entrepreneurs, who want cheap money and easy credit and rapid growth, against the aspirations of people with capital, who want stability and a safe return on their loans? It’s one of the central questions of American politics.

One answer has been basing the money on a commodity–usually gold, or silver, or both. Governments can’t make more gold: the supply is limited to what’s already in the earth. Make gold the standard, and you prevent inflation and irresponsible “tampering” with the economy. For some people discussion ends there: belief in gold is fixed with religious certainty.

There’s some problems with a gold standard, like lending. A bank puts $1000 in gold in its vaults, and in order to make money, it lends out $2000 to men on the make–small businesses, home buyers, etc. What is it lending? If only gold is money, it can’t really lend what it doesn’t have. So it issues more than it has–it prints up paper banknotes redeemable in gold so long as everyone doesn’t show up at once. This is called fractional reserve lending. It’s pretty much the magical foundation of capitalism.

The historical way to restrain this magical process was to require gold reserves–“you can lend a certain amount of paper notes above your gold reserve, but no more, Mr Banker, by law.” Theoretically, the money you loaned to people came back to you as gold, which they got from somebody else, which was part of the problem. Gold is “inelastic.”

Imagine you are an entrepreneur, inventive and energetic, on the frontier. You want to borrow money to start a business. But the local banks all say they can’t loan any more, because they only have so much gold in their vaults. Most of the gold collects in eastern seaports, to buy foreign goods. There just isn’t any gold, any money, around. You scratch your head and say “My labor turns this frontier town into a city, not gold. This arbitrary reliance on gold chokes my enterprising spirit! I want paper money to symbolize my labor!” You have to invent a new way to symbolize your labor. On a strict gold standard, you can’t.

In the years before the Civil War, Americans used an astonishing variety of types and kinds of money, all designed to evade the limits the gold standard imposed. Every bank could print its own money: there were more than 8000 more or less legitimate banknotes in circulation. There were also unchartered private banks which issued money, sometimes in millions of dollars. Some people had slaves, who functioned like gold in the southern economy, forming the collateral for loans and issues of private paper. Individuals and small businesses also printed small denomination “shinplasters” or stamped their own satirical or promotional token coins: these also amounted to millions of dollars. And there was massive counterfeiting: at times as much as forty percentof the money in circulation was counterfeit.

So again there’s a fundamental tension in American history between those who want loose money and easy credit and those who want stability and freedom from political interference. The loose money party sees the gold standard as arbitrary, a sneaky way to empower the rich by artificially limiting the money supply. The rich see paper money as a a cheat, a way to defraud creditors by giving value to something which has none. Both sides have a point: there is no easy way to resolve this tension.

The Bank of England offered one model. The BOE, founded in 1694, held the government’s assets–it was the British government’s banker. But it was run by a group of private citizens, its Board of Directors, and it sold stock like a private company. In return, the BOE got to lend money to the government and to other banks, in the form of paper Bank of England notes. Ideally, the bank’s sober, conservative directors would restrain the government, and other banks, from borrowing or lending too much in exuberant times, and help it out in hard times. The BOE could set interest rates and either thereby encourage growth or slow it down.

The US twice tried something similar: the First and Second United States Banks. Both looked a lot like the BOE, and both were allowed to lapse, partly because of popular hostility to the idea that a small group of men, granted an exclusive privilege by the govt., would have the right to set interest rates.

The Federal Reserve marks a third attempt to manage the conflicting desire for expansion and stability.

The Federal Reserve System, established in 1913, is a set of twelve banks in different regions of the US.[1. Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco]. These banks own the “Federal Reserve System.”

The Federal Reserve banks are the bank of the United States government. They handle the Treasury department’s payments, buy and sell government securities, and more or less do for the government what a bank does for you. Other banks can become members of the Federal Reserve System by buying stock in the twelve regional banks. In return they get discount borrowing but also stricter reserve requirements.

Each regional bank has a board of directors who are supposed to represent different “classes” of Americans. “Class A” directors represent commercial banks in the Federal Reserve System—they are the regional bank’s stockholders. “Class B” directors were intended to represent the public and the full range of what “the public” does for a living. They can’t be officers, directors or employees of any bank. Class A and B directors are elected by member banks in the regional district. The final class, “Class C,” also represents the public and cannot be directly involved in any bank: these persons are appointed by the board of Governors of the Federal Reserve to one year terms.

This complex structure reflects the public/private nature of the system, and the mixed feeling Americans have always had about money and money creation. The Class B and C directors, theoretically “just folks,” are there to insure that the Fed looks beyond the interests of bankers themselves and the country clubs at which they dine. But bankers elect or appoint them; they’re basically tokens. The Fed responds to the urgings of democracy mostly through its Board of Governors.

The President of the United States appoints the seven Governors, each named to fourteen year terms. One of them, the Chairman, gets a four-year term renewable at the President’s pleasure. This last is democracy’s big moment to influence policy. The current occupant of this majestic seat is Ben Bernanke, who is independent of both the President or Congress–neither has an statutory power over him after he’s appointed.

The Federal Reserve Banks issue “Federal Reserve Notes,” our money. The System affects the quantity of money, the amount in circulation, in several ways. One is the Federal Open Market Committee, composed of the Board of Governors, the President of the Federal Reserve Bank of New York, and the Presidents of four other regional Federal Reserve Banks.

The Open Market Committee buys or sells government bonds. [1. What’s a bond? A bond is a way for the government to borrow. The govt. says “buy this savings bond from me for $100, and in ten years we’ll pay you $200.” The Treasury “floats” an issue of bonds, and who buys them? You and me. But also the Fed and more significantly, China.] When the Fed buys bonds from the government, it puts money into the economy, causing inflation and lowering interest rates. When it sells bonds, it takes money out of the economy, reducing inflation and raising rates..

The Committee can also adjust the reserve requirements of member banks and thereby reign in or encourage lending. More significantly, the Open Market Committee also adjusts the interest rate at which member banks can borrow money—known as the “discount rate.” As of this writing, member banks of the Federal Reserve can borrow money at practically zero interest. They can lend this money to other banks and to private individuals, and eventually what they borrow for nearly nothing you borrow for, say, six percent.[2. At each stage in this lending chain, money is created in a multiplier effect. Imagine the Fed loans, say, ten million dollars to a member bank. Economists call that initial loan “high powered money,” because it will increase as member banks loan it in turn. The member bank takes that ten million and loans twenty million to its customers, most likely businesses and local banks, and those banks in turn then lend forty million dollars to their customers: voila: money has been created.]

Why, you may ask, do member banks get to borrow against our collateral (the bonds and the Treasury’s deposits) for nearly free and then lend it back to us for profit? And how come a small group of unelected bankers get to decide how much I pay for a car loan? Or how many bonds the Treasury can sell?

Money creation has never been free of insider advantage; never been free of mystification, and it has rarely been particularly democratic. If it was “democratic,” everyone would have as much as they want, which would never be enough, and inflation would run wild. The system was designed to connect the private interests of wealthy bankers to the federal government. Their self-interest would restrain the government and make sure it didn’t run wild with paper: that same self-interest would act to stimulate growth.

The Fed was supposed to weigh growth against stability and make adjustments as needed–increasing the money supply here, decreasing it there, to maintain a robust but controlled rate of economic growth. We are all supposed to trust in the wisdom of a group of central bankers, who have been carefully insulated from political pressure. It’s a balance of public and private, government and commercial, that’s unlike anything contemplated in the Constitution. But it’s not unlike the 1st and 2nd US banks, and the BOE.

And at this point, in 1913, the U.S. still enjoyed a gold standard, and the idea that “real money” was a magic commodity, limited by nature, which nevertheless “backed” American money. So even though the Fed could expand or contract the money supply at its own whim, the psychic idea of the gold standard remained in effect.

Today the Board of Directors scrutinizes economic figures–GNP, prices, employment statistics, import and export figures, etc.–and makes a decision about how much money we should have. The Fed is extremely anxious about inflation–although the Fed is constantly criticized for simply “printing money,” since the 1970s it’s been extremely inflation averse. At the moment, unemployment is about ten percent. In classical theory, causing inflation would end that unemployment. But it would eat into the bottom line of large banks.

“Monetarism,” an economic philosophy associated with Milton Friedman, argued that the Fed should simply get out of the way–its tampering only makes things worse, it’s always behind the curve, it represents a “distortion” of the market. The Fed should be, he argued, pretty much just a single clerk at a desk, limiting monetary growth to an automatic and unvarying figure, say 3% a year. That way you’d have stability and flexibility and less political tampering. Friedman was top dog till the crisis of 2008, when apparently the forecast was so scary that they all rushed back into the arms of Keynes.

Your author sometimes dramatizes the issues involved in the Fed by assigning “O’Malley’s Utopian Banking Scheme. It offers an alternative model of money creation, one aimed at eliminating the “middleman.”

I’m not an economist, and I don’t make policy. The Fed represents a pragmatic attempt to balance competing interests against each other: in my opinion it’s tilted way to far in favor of a few huge banks, and it’s enabled too much movement of wealth up, into the hands of the very rich. I’d be happy to have a debate about what to replace it with. I’m not a gold standard guy though–I’m much more inclined to agree with Franklin.

Mike wrote: “The member bank takes that ten million and loans twenty million to its customers […]”

I don’t understand this — how can a bank lend more than it gets? Are you referring to “Fractional-reserve banking”? If so, I don’t think you are describing it quite right.

Bank X gets $100 and can lend out $90 (e.g. if it must reserve 10%). That $90 can then be put into Bank Y which can lend out 90% = $81. So the initial $100 has resulted in $171 in loans and $19 in reserves so far. That is the nature of the multiplication as I understand it.

Mike wrote: “Milton Friedman, argued that the Fed should simply get out of the way […] Friedman was top dog till the crisis of 2008, when apparently the forecast was so scary that they all rushed back into the arms of Keynes.”

You seem to be saying that before 2008, the Fed “simply got out of the way”. Is this correct? I don’t know enough to judge with authority, but I’m curious what your source is for that.